The P/E Ratio, Health Care, and You

There are a million metrics to judge stocks by: debt-to-equity, return on investment, EPS growth -- you name it, someone in the financial industry has come up with it. But as an investor in the health care sector, how do you make sense of all these symbols and fancy names? While judging a stock is very much a personal call, let's get caught up on how the most fundamental of stock metrics -- price-to-earnings, or the P/E ratio -- matters in the health care industry. Between small biotechs and well-entrenched big pharma goliaths, should you put worth in this time-honored number?

The fundamentals of the P/E ratioLet's review the basics of the P/E ratio. This metric provides a quick (and often useful) valuation of a stock in question -- that is, it tells you what you're getting for your money. It's calculated by taking the price of a single share and dividing it by the company's earnings per share over the last 12 months.

Here's an example: Say Company A's stock sells for $20 per share; over the last 12 months, its earnings per share were $2. The P/E ratio in this scenario is 10 -- good for investors, as lower numbers tend to indicate a cheap stock, while higher P/Es usually indicate expensive stocks. A P/E of 10 tells you that you're paying $10 for $1 of past earnings.

In the health care industry, Pfizer (NYSE: PFE) records a P/E of 19. That's less than Johnson & Johnson's (NYSE: JNJ) P/E of 22; thus, by the ratio, Pfizer's stock is cheaper. It also says that investors expect more earnings growth in the future from J&J, however, since investors are willing to pay more for each share. Typically, higher P/E ratios indicate that investors foresee higher earnings than stocks with lower P/Es.

It's usually better to invest in cheaper stocks with lower P/Es, as the price typically catches up to earnings in meeting the market average -- with the average S&P 500 stock trading at a P/E around 15. With low P/Es, the price will often rise to meet the market average over time; high-priced stocks will see their value eventually sink if earnings don't continue to rise. But P/E ratios alone don't tell the whole story. When should you trust this metric in the health care industry?

Big pharma and P/Es go well togetherIn the world of big pharma companies like the aforementioned Pfizer, P/Es can be a valuable tool. Since these corporations are well-established with large portfolios of medications and prospects, along with steady earnings that can be tracked over many years, investors can confidently compare valuations safely.

Let's go back to Johnson & Johnson and Pfizer to see how this works. On any financial website, we can easily find data on either company's earnings over the past few quarters and years; using this, it's easy to calculate the P/E. Pfizer and J&J report annual earnings in the range of nine or ten digits year after year; it's a consistent pattern that you can safely trust when applying valuations.

Other big pharma players, such as Merck (NYSE: MRK) and Sanofi (NYSE: SNY) , work the same way, as they consistently report significant profit year after year and boast huge portfolios of products. Big pharma companies are the foundation of the health care industry; they're far more stable than small biotech start-ups looking to make it big on one or two blockbuster drugs.

The P/E ratio and small biotechs don't alignIt's not so black-and-white when trying to apply the P/E ratio to small biotechs like hepatitis vaccine developer Dynavax (Nasdaq: DVAX) . Many small biotechs don't even record earnings, since they're still testing a single drug that makes up the entirety of their company. Success lives and dies by the fate of one drug; there is no large portfolio like with Pfizer and Merck. Without a drug on the market yet, they record no income and little, if any, revenue.

Because Dynavax, Mannkind, and similar companies record losses rather than earnings -- they have no products they can sell, after all -- the P/E ratio becomes a rather useless statistic. You can't divide over a negative number.

What should you watch with these small companies? Dynavax and other biotechs are far more volatile than big pharma companies, and there's a few key events you need to hone in on. Watch instead for how clinical trials of biotech drug candidates work out; do phase 3 trials show positive signs? When these trials go well, shares can jump -- as they did back in 2009 when obesity drugmaker VIVUS (Nasdaq: VVUS) posted positive clinical results. Additionally, check out the company's burn rate, or how quickly it chews through cash on hand.

The boom-or-bust moment comes in the FDA approval of a drug, which -- for small biotechs like Dynavax -- can mean life or death depending on an approval or rejection.

It's got its usesIf you're into health care's biggest and safest players, by all means take P/E valuations into account when judging these stocks. It's a good starting point for such large, well-established companies that can continue to crank out billions of dollars in earnings every year. If small, speculative biotech companies with the potential to land blockbuster drugs intrigue you more, however, the P/E ratio won't help you until these companies find success. In the end, I encourage every investor to do due diligence beyond simple ratios for every buy and sell; but by understanding this fundamental ratio and when it's useful, you can better understand your stocks.

Small biotechs like VIVUS hold some of the best potential on the market-but they can also crash and burn in spectacular fires. Is VIVUS, with its drug to fight the ongoing epidemic of obesity, the biotech star of the future? The profit opportunity is immense for this bright company but plenty of risks still exist, so make sure you understand the full story behind VIVUS in the Fool's brand new premium research service. It's such an important story that we have our top health care writer on the job, so make sure to secure a copy today by clicking here now.

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